Tax Minimization with IC-DISCs

The IC-DISC legislation was passed a number of years ago by the US Congress to promote export activities. The State of Oregon recently passed favorable legislation for IC-DISCs formed prior to January 1, 2014. The federal law allows an IC-DISC (a general business corporation) to receive commissions on export activity on a tax-free basis if certain regulations are followed. It can further accumulate capital over a period of years and only have to pay the federal government an interest charge on deferred taxes, hence the IC acronym standing for “Interest Charge.” The DISC acronym stands for “Domestic
International Sales Corporation.” When the IC-DISC pays a dividend to its stockholders, they currently pay a maximum federal rate of 20% plus the NII tax (3.8% Net Investment Income tax on joint individual returns with adjusted gross income of more than $250,000), if applicable. Oregon has taken a slightly different approach and limits the IC-DISC tax on its income to 2.5%, and makes dividend payments from it tax free. Bottom line is that this arrangement potentially creates significant tax savings.

CORPORATE STRUCTURE

The IC-DISC can’t be owned by the exporter. Typically its stockholders are the owners of the exporter. It must also have the same tax year as a majority of its stockholders. Other than following the IC-DISC rules, it looks and feels a lot like a regular corporation.

COMMISSION CALCULATION

A commission contract must be in place between the IC-DISC and the exporter. The commission can be calculated in one of two ways: 4% of qualifying export sales or 50% of net profits on qualifying export activities. One of the more significant definitional issues is that the exporter must be able to trace its products into the export sales in substantially the same form. Thus if the exporter’s products are altered in a significant way they will not qualify for the commission. This is referred to in professional literature as the “fungibility test.”

EXPORTERS IN GENERAL

In the past the IC-DISC strategy worked well for large exporters. Export assets, including capital assets used in export activities could be acquired by the IC-DISC at a very low tax cost. Smaller exporters generally didn’t want to tie up their capital in this manner. But
with the advent of capital gain rates being applied to dividends the IC-DISC provides a way to convert ordinary income potentially taxed at high rates to dividend income that is currently taxed at capital gain rates. If there are enough qualifying export sales to overcome the related overhead of operating this structure, it works for small as well as large exporters.

AGRICULTURE

Many agricultural crops are exported. Where crops are processed and/or substantially changed the fungibility rule applies and disqualifies sales of crops at the farm level. If the farmer’s crops otherwise qualify, but are comingled in a cooperative crop pool where they can’t be traced into the export sale they will also be disqualified. In some circumstances farmers are able to conduct their business in such a way as to preserve traceability and fungibility so that an IC-DISC will work for the farming business.

AGRICULTURAL COOPERATIVES

The IC-DISC legislation was not designed with agricultural cooperatives in mind. Cooperatives are not allowed to pass the benefits of the IC-DISC legislation through to member patrons such as they are allowed to do with DPAD (Domestic Production Activities Deduction). This forces the need for a parallel structure where the member patrons own a pass-through entity that holds the stock of the IC-DISC. So the cooperative pays the IC-DISC a commission on its export activities, the IC-DISC issues a dividend to
the partnership or limited liability company holding the stock, and then this entity makes distributions to its partners/members who are also the cooperative’s patrons. As a practical matter, all member patrons should be part of this arrangement or they will lose
their share of the commission paid to the IC-DISC. The partnership or limited liability company would need to adjust its profit sharing ratio annually to conform to patronage
allocations. Although complicated, it can be done by utilizing Section 704 IRC Regulations for special allocations of income. There are other challenges with cooperatives as well, but some are making the IC-DISC rules work to their advantage.

CONCLUDING COMMENTS

It is clear that while Congress intended to provide a stimulus to creating exports, the IRS has in turn written regulations that require close compliance or the benefits will be lost. What happens should the IC-DISC be found in violation of IRS Regulations? The worst case scenario is that the corporation would lose its IC-DISC status and dividends would be double taxed. If this were to happen the arrangement would be discontinued. Another risk is that the government could change the tax laws. This risk is ever present, and again the same answer would apply. The arrangement would be discontinued.